THE MAIN DIRECTIONS OF THE IMPACT OF THE EURO ADOPTION IN LITHUANIA
SCENARIOS FOR THE QUANTITATIVE ASSESSMENT OF THE IMPACT OF THE EURO ADOPTION
RESULTS OF THE QUANTITATIVE ASSESSMENT OF THE EURO ADOPTION BENEFITS
The impact of the euro adoption on interest rates and payable interest
The impact of the euro adoption on currency exchange costs
The impact of the euro adoption on Lithuania’s exports and investment
The impact of the euro adoption on the country’s GDP and employment
How much could have Lithuania saved if it had adopted the euro in 2007
ONE-OFF COSTS AND ADDITIONAL FINANCIAL CONTRIBUTIONS RELATED TO THE EURO ADOPTION
QUANTITATIVE COMPARISON OF THE BENEFITS AND COSTS OF THE EURO ADOPTION
ANNEX. The main quantitative estimates of the possible benefits of the euro adoption in 2015 for the Lithuanian economy
The Bank of Lithuania has carried out a quantitative assessment of the likely impact of Lithuania’s strategic objective — the adoption of the euro in 2015 while joining the euro area — on the national economy, and prepared an overview of this assessment. The overview presents a quantitative assessment of the likely economic benefits of the euro introduction; it also estimates the likely amount of the costs related to the changeover and Lithuania’s additional financial contributions and liabilities to international institutions.
The research aims to more exactly define the economic benefits and costs of the euro adoption, and to compare them in the short, medium and long term1.
The results of the quantitative research suggest that the positive impact of the euro would be long-term and would significantly exceed the short-term costs as well as the amount of Lithuania’s additional financial contributions. In order for the country to be able to take full advantage of the benefits of being in the euro area to the best possible extent, it is necessary that the economy would effectively use the period of declining interest rates to enhance its competitiveness, and that focused economic policy would ensure fiscal sustainability and macroeconomic stability. It is important to emphasize that the potential positive impact of the euro adoption has been assessed conservatively, considering that in Lithuania in 2013, i.e. a period of relative calm, relatively low interest rate margins between the respective financial transactions in litas and euro (loans, deposits, debt securities, etc.) were observed. However, the benefit of the changeover would become even greater in periods of interest rate instability – being within the euro area, in combination with the country’s appropriate economic policy, would enable avoiding such leaps in interest rates as were observed in Lithuania in 2008–2009.
This overview analyses the direct and indirect effects of the introduction of the euro on Lithuania’s various economic variables in 2014–2015, the indirect effects on the GDP and its components in the medium and long term (see Chart 1).
Chart 1. The main directions of the impact of the euro adoption in Lithuania
Note: the dark arrows mark the quantitative impact as directly defined in the overview, the lighter ones — that the quantitative impact was not directly defined but was estimated indirectly as a component of the factor group.
The impact of the euro introduction on the Lithuanian economy can be classified into direct, which will manifest itself automatically in the short term, but may also last into the long term, and indirect (via other variables), which depends on various circumstances and more often, though not always, manifests itself during a longer time:
• direct impact: the substitution of the litas for the euro would reduce interest rates due to a decrease in foreign exchange risk, reducing at the same time foreign exchange and accounting costs, enhancing the balance of the currency structure of the public and private sector’s assets and liabilities, and expanding the possibilities for managing liquidity in the banking sector.
• indirect impact: the adoption of the euro may positively affect the country’s credit rating (which would reduce interest rates even more), it would encourage investment and foreign trade, speed up the growth of the economy and the welfare of the public.
When analysing the effects of the introduction of the euro, two scenarios for a decline in interest rates were chosen. They are presented in Table 1.
The overview relies on the assumption that interest rates for Lithuania’s economic agents, due to the planned introduction of the euro in 2015, will gradually decline in 2014 and will later change due to the secondary effects of macroeconomic variables.
Table 1. Scenarios for a decline in interest rates due to the adoption of the euro
The probability of the upgrading of the country’s credit ratings increases due to the fact that international credit rating agencies see the introduction of the euro in Lithuania as a factor which diminishes credit risk. The agencies are confident that, for the Baltic States, the benefits of joining the euro area are greater than the risk of an increase in the financial costs related to support to the euro area member states facing the debt crisis. They list the following specific aspects of the positive impact of the changeover to the euro:
- the country risk and the risk for households and businesses, related to the currency structure of their income and liabilities, will decrease, as currently their major income share is in litas while the liabilities share is in euro;
- the country’s access to the financial markets and capacities of liquidity management for the banking system will improve;
- predictability of the country’s economic policy will increase.
In the year before the introduction of the euro, rating agencies upgraded credit ratings for Estonia and Latvia by 1–2 grades, as one of the reasons specifying the forthcoming adoption of the euro (see Chart 2).
Chart 2. Development of the credit ratings for Estonia’s and Latvia’s long-term debt in foreign currency during a one-year period before and after the adoption of the euro
Note: The rating agency Moody’s in March 2010 left unchanged the rating of A1 for Estonia’s long-term debt in foreign currency, but upgraded its perspective from negative to stable (in the Chart it is depicted by a little increase of the curve level).
Source: Rating agencies and BoL.
The rating agencies point out that, in pursuit of further upgrading of the rating, the following is needed:
- further structural reforms to reduce unemployment and promote investment:
- decline in the debt-to-GDP ratio;
- strengthening of the euro area economy, which would enable expanding the country’s exports even more.
As can be seen in Chart 2, following the changeover to the euro, Fitch and S&P upgraded Estonia’s rating again. The upgrading was based on the country’s good economic growth prospects, combined with exclusively robust public finances, the decreasing ratio of private sector external debt to GDP, and consensus among the ruling political parties on prudent economic policy.
The results of the assessment of the impact of the introduction of the euro on the interest rates at which Lithuania’s economic agents would borrow, based on the two scenarios discussed above, are presented in Table 2.
Table 2. Scenarios for a decline in interest rates due to the adoption of the euro
The adoption of the euro would decrease the average interest rate at which the Government of the Republic of Lithuania would borrow in 2015 by 0.80 p.p. under Scenario 1 and 0.18 p.p. under Scenario 2. Having analysed the impact of the introduction of the euro on the interest rates on the long-term (10 yrs.) debt securities of the governments of Slovenia, Cyprus, Malta and Slovakia on an individual basis, it turned out that joining the euro area reduced these interest rates by an average of 0.51 p.p. The obtained value is between the values of Scenario 1 and Scenario 2, and closer to the estimate of Scenario 1 (baseline).
Having taken into account the projected development of public debt, GDP and interest rates, it was estimated that the public debt management costs-to-GDP ratio under Scenario 2 and Scenario 1 would gradually decrease from 0.01–0.03 p.p. in 2014 to 0.04–0.13 p.p. in 2022. The Government of the Republic of Lithuania mainly borrows by issuing debt securities with a fixed interest rate, therefore the introduction of the euro would not change the interest rates payable on its previously issued debt securities. Securities issued after the introduction of the euro would in 2022 have already replaced most of the debt securities issued before. Annual cost of public debt management in 2014–2022 would be lower by an average 0.03–0.10 per cent of GDP, and would decrease by LTL 0.4–1.6 billion during this period all in all.
Having assessed the impact of the introduction of the euro on the interest rates on loans to Lithuania’s non-financial corporations (hereinafter — corporations) and households, it followed that the average interest rate in 2015 would be lower by 0.53 p.p. under Scenario 1 and 0.31 p.p. under Scenario 2. Unlike in the case of public debt, a decrease in the interest rates on loans to the non-financial sector would cheapen not only new loans, but most of the loans extended previously in litas and euro as well. The interest rates on most such loans are variable and linked to the interest rates VILIBOR and EURIBOR, and, from 2015, EURIBOR would replace VILIBOR.
Data analysis led to assuming that the amount of the interest rates of deposits and resident debt securities held by Lithuanian corporations and households would get a little impact from the euro adoption and, therefore, this sector of the economy would save interest rates on loans, earning a similar amount of interest on deposits to that before the adoption.
Considering the projected development of loans and deposits, as well as interest rates on them and GDP, it was estimated that the net interest rate costs of Lithuanian corporations and households in the medium term (2014–2022), under Scenario 1, would be less by 0.14–0.23 per cent of GDP, under Scenario 2 — 0.10–0.13 per cent of GDP per year. During this period, this sector of the economy would save a total of LTL 1.6–2.3 billion: corporations — LTL 0.7–1.1 billion, households — even more: LTL 0.9–1.2 billion.
The introduction of the euro would reduce the currency exchange costs of Lithuania’s non-banking sector. There would remain no litas and euro exchange transactions and transactions to hedge against litas exchange rate risk. Based on Lithuania’s currency market data for 2010–2012, it was estimated that the costs of litas and euro exchange and of hedge against litas exchange rate fluctuations would be 0.14 per cent of GDP annually. Calculations suggest that in 2015–2022 the non-banking sector would save about LTL 1.9 billion.
The decline in Lithuania’s non-banking sector’s costs on banking operations would curtail the revenues of banks operating in the country in the short term, curtailing the credit risk and currency exchange risk assumed at the same time. Banks would be able to develop their activities in Lithuania at lower cost of capital and expect more stable returns. In the medium and long terms, bank revenues could increase due to credit development, which would be driven by likely stronger economic growth and the would-be larger debt-to-GDP ratio.
Chart 3. How much the Lithuanian government, corporations and households would save if the euro is adopted
For the non-banking sector, the total positive impact of the drop in interest rate and currency exchange costs in 2014–2022 would amount to LTL 4.0–6.0 billion, or an average of 0.27–0.40 per cent of GDP annually (see Chart 3).
The introduction of the euro would have a positive impact on Lithuania’s foreign trade due to lower trade and market entry costs, the attitude of businesses towards the euro area as a single market and increased foreign investments, market transparency, and competition. The experience of the euro area countries shows that the introduction of the euro increased the foreign trade of these countries by 5–10 per cent.
In assessing the likely impact of the 2015 introduction of the euro on Lithuania’s exports, the overview adopts a conservative assumption that real exports (excluding mineral products), due to the introduction of the euro, in 2015–2022 should increase by 5 per cent. This would make LTL 34 billion during this period (see Chart 4). It was based on the results of international studies on the impact of the adoption of the euro in the “euro-ins” on their foreign trade. Among the estimates provided in these studies, a conservative (lower) value was selected, which takes into account the fact that since 2002 Lithuania has chosen a fixed exchange rate of the litas against the euro, and since 2004 it has been a member of the EU, since both of these factors also increase a country’s foreign trade and export.
Chart 4. 2015–2022 increase of real exports (excl. mineral products) in absolute amounts
The impact of the euro on foreign trade and foreign direct investment (FDI) was examined through the effect of the euro on foreign trade. The introduction of the euro would provide preconditions for the increase in FDI, and FDI and foreign trade are closely related. The results of international studies on the experiences of the “euro-ins” are very different; therefore, choosing a quantitative estimate in the case of Lithuania is difficult. Taking this into account, during this study, FDI increase was not estimated quantitatively. A cautious attitude towards the impact on FDI in Lithuania of joining the euro area is motivated by the fact that for more than a decade Lithuania has been a member of the EU, while the litas against the euro has been on a fixed exchange rate for an even longer time.
By means of the LTDSGE model3, the effect of the interest rate decrease and export increase on the GDP was assessed. It was revealed that Lithuania’s real GDP in the medium and long term would be larger than if the euro would not be adopted (see Chart 5). In 2014–2022 the real GDP in the case of Scenario 1 would vary from 0.5 to 2.8 per cent (on average, 1.9%), while in the case of Scenario 2 — from 0.3 to 2.6 per cent (on average, 1.8%) larger. Lithuania’s real GDP in the long term would be 1.3 per cent larger that if the euro would not be adopted.
Chart 5. Estimates of increase in real GDP level due to euro adoption
The impact of the interest rate decrease on Lithuania’s real GDP in the long term would be greater if the country’s corporations would invest actively in activities, essentially increasing the economy’s competitiveness. The period after the introduction of the euro could be more favourable to such investment due to expected lower real interest rates, which will allow corporations to invest at a lower cost, for a longer period of time.
The euro would increase employment in the medium term, but its increase in the long term will require structural reforms for harmonising labour supply and demand. It was estimated that unemployment in 2014–2022 would, on average, be 0.4–0.5 p.p. smaller, while employment — higher by 6.9–7.4 thousand persons (see Chart 6). In the medium term, the decrease in the level of unemployment would be a result of greatly increased labour demand. Since corporations would require time to accumulate the required amount of physical capital, the increased demand for their products would initially be satisfied by hiring more new workers. However, later, the impact of the euro on unemployment and employment would decrease. In order to decrease structural unemployment, it would be necessary to continue to perform targeted structural reforms to harmonise labour supply and demand.
Chart 6. The adoption of the euro would decrease unemployment and increase employment in the medium term
The benefits of the introduction of the euro would be even larger in periods of interest rate instability. Earlier presented benefit estimates were calculated conservatively, taking into account the interest rate level, prevailing in 2013 in Lithuania, which is a relatively calm period. Therefore, the survey also evaluated how much Lithuania was able to save in interest payments and currency exchange costs, if it would have been able to adopt the euro in 2007. It is concluded that Lithuania would not have avoided the economic downturn in 2009, the sharp increase in the state budget deficit and debt in 2009–2011, the need for structural reforms to maintain economic competitiveness and a heavy reduction in the budget deficit in later years. Lithuania actually did so without adopting the euro, but another conclusion is that the implementation of these measures being a member in the euro area would have allowed avoiding the drastic spike in interest rates in 2008–2009 which was observed due to increased distrust of the markets in the stability of the litas exchange rate. The increase of the interest rate in Lithuania in the second half of 2011 and first half of 2012, when some of the euro area countries’ debt crisis exacerbated, would have been modest, as can be seen from the Slovak example (see Chart 7).
Chart 7. The 5 y. credit default swap interest rates of the Baltic states and several other European states
In assessing Lithuania’s savings if it had adopted the euro in 2007, two scenarios were examined. Under Scenario 1, our country until 2009 would maintained an A level credit rating, as was in the case of Slovakia, which has been part of the euro area since 2009. This country, by its economic development and many macro-economic indicators, is similar to Lithuania in many ways. According to Scenario 2 (conservative), it is assumed that Lithuania’s economy, even being in the euro area, in 2009 would have experienced a greater downturn than Slovakia’s economy, so our country credit rating developments would have coincided with the actual dynamics. Lithuania’s credit ratings in 2008–2009 would have been downgraded to the BBB level and would have remained so until the end of the period under review.
The results of Scenario 1, if taken as the upper limit of the saved funds, while Scenario 2 — as the lower limit, show that the Republic of Lithuania’s public debt management costs in 2007–2012 could have been LTL 1.6–1.9 billion, or 20–24 per cent less than the actual costs. This would have comprised 0.25–0.31 per cent of the GDP generated over the period. Lithuania’s debt management costs for the government debt securities issued in 2007–2012, during the period of validity (2007–2022) would have been lower by almost LTL 4.1–4.9 billion, or 0.19–0.22 per cent of the projected GDP over this period.
Lithuania’s non-financial corporations and households for the period 2007–2012 could have saved LTL 1.2–2.1 billion in interest, or 9–16 per cent of the difference of the actual interest paid on loans and interest earned on deposits. This would have comprised 0.20–0.34 per cent of the GDP generated over the period. The decrease in currency exchange costs would increase the aforementioned amount by LTL 0.9 billion or 0.14 per cent of GDP. In contrast to the general government, the benefits of lower interest rates on loans for the non-financial sector in Lithuania would have been greatly reduced by lower interest rates on deposits, while it had relatively few resident debt securities. It is estimated that under both scenarios the interest on deposits would have decreased similarly — by about LTL 0.9 billion.
Thus, if Lithuania would have adopted the euro in 2007, the country’s general government and the private non-financial sectors for the period of 2007–2012 together could have saved LTL 3.7–4.9 billion, or 0.59–0.79 per cent of GDP. Having added the economies on the interest on the debt securities issued in this period by the Republic of Lithuania, throughout their duration the financial benefits could reach LTL 6.2–7.8 billion.
In order to evaluate the overall impact of the targeted euro adoption on the Lithuanian economy, the overview quantitatively assessed the changeover one-off costs and the additional financial contributions the country will have to pay to international institutions. The results are summarized in Table 3.
The one-off euro adoption costs include the one-off price level increase and the adoption costs of Europe’s single currency.
According to the results of international studies, it is believed that the introduction of the euro in Lithuania should have a short-term one-off impact on the price level: in the first months of 2015 it would increase by 0.2–0.3 p. p. Such estimates were received by Eurostat, which examined the situation in Estonia and other countries that adopted the euro after 2007.
International research shows that the one-off increase in prices, when the countries join the euro area, is triggered by four key factors:
• rounding of prices and the desire of sellers to make them attractive;
• the shift of some euro adoption costs onto consumers;
• the so-called consumer “rational inattention” (it is difficult for a consumer to evaluate at the same time all the price changes, and in some cases they don’t even try to remember them due to their small size, and sellers can make use of this);
• synchronisation of price changes (usually prices are revised gradually, while during the euro adoption prices will be revised at the same time).
In the government-approved National Changeover Plan, taking into account international experience, various instruments are provided, which will help prevent unjustified price increases and strengthen consumer positions.
One of the main instruments — the requirement to indicate dual pricing in litas and euro of goods and services before the changeover. The National Changeover Plan provides that dual pricing will be implemented 60 days after the Council of the European Union makes the decision in regard to the setting of an irrevocable conversion rate of the litas and the euro and will last for one year after the adoption of the euro. A particularly important role will be played during the euro adoption period by the control institutions, which will check how prices are converted and whether they are indicated correctly, they will address consumer complaints, impose sanctions for violations and publicize offenders. The National Changeover Plan also provides that price changes for the essential goods will be actively monitored and announced. The public and consumer organisations should also be actively involved in price monitoring. According to the National Changeover Plan, businesses will be encouraged to sign the Code of Good Business Practice. Economic agents that sign this Code will undertake to abstain from using the euro as a pretext for raising prices. Such businesses will have clear identification marks.
The total one-off euro adoption costs in Lithuania, taking into account the experience of foreign countries, could amount to up to 0.5–0.7 per cent of GDP (LTL 0.6–0.9 billion).
Tentatively and conservatively evaluating the potential one-off euro adoption costs in Lithuania, the top ratio between them and the GDP was selected to reflect what it was in Austria and the Netherlands, i.e. 0.2 p.p. higher than the European Commission’s published average (0.5%). Lithuania is dominated by small and medium-sized corporations, which would increase the ratio of the one-off cost of the euro adoption to the GDP. Net euro adoption costs in Lithuania should be much lower, as part of preparations for the euro adoption will replace the usual work of updating the information and other systems, and part of the euro adoption-related orders will go to Lithuanian companies.
Lithuania’s accession to the euro area would increase the country’s financial contributions to international institutions, but it would mean investment rather than costs.
• In 2015–2019 Lithuania should transfer to the European Stability Mechanism’s (ESM) paid-up capital about EUR 300 million (about LTL 1 billion), as is currently provided in ESM documents. The available information suggests that the transfers should be arranged as five instalments of about EUR 60 million (LTL 200 million) in 2015–2019. Lithuania would also commit to supplement the ESM capital with up to EUR 2.5 billion (LTL 8.5 billion). Additional contributions to the ESM capital may be needed if the debt crisis would deepen in some of the euro area countries and would spread to new countries, but this is not the main scenario of this study;
• The income generated by the ESM operations and sucessful repayment in creditor debts will earn a return, which will increase the value of the share of capital invested by Lithuania. While in the coming years the possibility of return is low, it is basically envisaged that when the ESM reaches the total lending capacity and the euro area countries will no longer need its help, the ESM may pay dividends (reducing the profits earned by operational costs) in proportion to the country’s contributions;
• The BoL would transfer an additional EUR 43 million (about LTL 148 million) contribution to the capital of the European Central Bank (ECB). This contribution would not require additional funds because it would use a small part of BoL assets (in comparison, BoL assets accounted for LTL 20.7 billion at the end of August 2013). The BoL would also undertake to proportionally contribute to covering the Eurosystem’s monetary policy operations’ and the ECB’s losses, if any;
• When Lithuania joins the euro area, the BoL would gain the right to a share of the ECB’s annual financial result, proportionate to the BoL’s share in the ECB’s paid up capital. The BoL would also gain the right to a proportionate part of the ECB’s profits and the Eurosystem’s monetary policy income, regardless of how many monetary policy transactions it would perform itself. The ECB’s net profit in 2012 amounted to almost EUR 1 billion. If Lithuania had been a member of the euro area, ir would have received 0.61 per cent, i.e. LTL 21 million. Non-euro area NCBs are not entitled to the distribution of the ECB’s profits.
It can be summarized that the impact on the national economy of the introduction of the euro is favourable for both the short and long term. Estimates show (see Chart 8) that the euro adoption net benefits are long-term and even in short term exceed the adoption costs and additional financial contributions. Furthermore, the latter aren’t simply costs.
Chart 8. The forecasted one-off euro adoption costs and financial contributions to the ESM capital comparison with the increase in the nominal GDP level due to the euro adoption compared to GDP if the euro would not be adopted, %
In addition, the ratio of the benefits of the changeover to the costs is indicated by the comparison of the nominal values (see Table 3).
Table 3. Euro adoption benefits and costs in nominal values
The long-term impact of the introduction of the euro on the national economy would be even greater if Lithuanian economy would use the period of real interest rates after the euro adoption for focusing investment in areas that would allow substantially increasing the country’s competitiveness.
1 In economic terms, the short, medium and long term are not time concepts, they mark different stages in an economy's adjustment to changes, and the introduction of the euro would be an example of such change. In the short term, an economy experiences the initial impact of the changes, which output and employment begin to react to. Usually, such a period lasts for about one year. In this specific case, it would be the year 2015. In the long term, the economy will completely adjust to the adoption of the euro, and its impact on Lithuania's macroeconomic indicators will stabilise — fade or settle to be at a stable level. To illustrate the impact of the adoption of the euro in the medium term, the period from 2014 to 2022 has been chosen, during which the impact of the euro, while changing, will reach a level close to that which will settle in the long term.
2 Two rating agencies should raise Lithuania's long-term credit rating in foreign currency by 1 grade, one agency — by 2 grades: Moody's should upgrade by at least 1 grade (from the current Baa1 to A3); Fitch — by at least 1 grade (from BBB+ to A–); S&P — by at least 2 grades (from BBB to A–).
3 In order to assess how the introduction of the euro would impact the GDP and its components (consumption, investment, difference between exports and imports) in the medium and long term, a dynamic stochastic general equilibrium (LTDSGE) model of the Lithuanian economy, developed by the Bank of Lithuania, was applied (Pušinskaitė R., Vetlov I. (2013). An Estimated Dynamic General Equilibrium Model of Lithuanian Economy. Mimeo). The transmission channel of the decrease of the average interest rate paid by Lithuanian economic agents and the export increase transmission channel, which connected the other potential transmission channels, were analysed separately. In analysing the transmission channel of the decrease of the average interest rate, the assumption was made that in a country that has adopted the euro, the interest rates include lower risk premiums than in a non-euro country with the same macro-economic indicators. In this overview the two average interest rate reduction scenarios were evaluated: from Q3 2014 under Scenario 1, the risk premium decreases by 0.56 p.p., while under Scenario 2 — 0.29 p.p. In analysing the transmission of the export channel, the earlier mentioned assumption on the overall export increase by 5 per cent over seven years (2015–2021) was used.